Because I was distracted today (houseguest, plus preparing for out of town trip), I haven’t spent as much time as I would have like on the Congressional hearings into the Bear bailout.
Judging from the media reports, it seems that the assertive presentations by the perps, um participants in the deal were not met with aggressive questioning by the assembled Congressmen. But the lack of sparks flying does not necessarily mean that they were persuaded. Supreme Court watchers warn that the demeanor of the Justices is seldom a reliable guide to how the court will rule. That observation may apply here.
Nevertheless, there were some priceless moments in self-delusion and
dissembling artful presentation. :
First is Bear CEO Alan Schwartz saying in retrospect that there was nothing he would or could have done differently; Bear had “adequate capital and liquidity.” The facts prove conclusively otherwise. Reading between the lines of the later testimony, that JPM and the Fed hint at a solvency problem (and not merely because Bear was on the verge of filing for bankruptcy). Schwartz came out of the investment banking side. He is highly unlikely to have been able to judge the quality of Bear’s riskier positions.
This is also a man who did not do well under pressure. Not only did his manifest discomfort during an investor presentation help seal the bond trading firm’s fate, but he mis-heard the deal that he got on Thursday from the Fed via JPM. It was an overnight loan so they could get into the weekend, while he thought it was for 28 days.
Taking Schwartz at face value, there was no real reason for Bear to collapse other than gossip. Merrill and Citigroup’s efforts to shore up confidence and their ability to meet obligations with capital infusions will not protect them. Bear, despite its failed hedge funds, quarterly losses and ousted chief executive, was in fantastic shape. “Adequate capital,” remember?
Except that there wasn’t. “There was a failure to understand the gravity of the problem,” according to Christopher Dodd, D-Conn., the committee chairman.
Second is the SEC soft-shoe, a bookend to Schwartz’s “everything was fine, really, it was those evil shorts.” According to the SEC, Bear did have adequate capital, that is, regulatory capital. When I started out on Wall Street, in the day of stone tablets and abacuses, even junior dweebs understood that SEC capital requirements were not often the consideration that dictated how much the firm was geared. And as debt instruments have become more complex and derivatives have skyrocketed, the SEC has remained primarily concerned with equity markets. So I’d expect regulatory capital requirements to be a binding constraint even less often than in the past.
In the New York Times, Floyd Norris pillories the SEC for its insistence that a failed metric is adequate. The SEC’s logic reminds me of LTCM chief John Meriwether’s stance after his fund failed. He continued to maintain that his models were fine. The problem was reality.
Bear Stearns never ran short of capital. It just could not meet its obligations…. “At all times,” wrote Christopher Cox, the S.E.C. chairman, in the aftermath of the collapse, “the firm had a capital cushion well above what is required to meet supervisory standards.”….Does it sound a little like a doctor emerging from a funeral to proclaim that he did an excellent job of treating the late patient?
“That kind of statement is a condemnation of the kind of supervision that the S.E.C. did,” said one expert on financial regulation, Edward J. Kane, a finance professor at Boston College, in an interview this week. “If there is good capital, you should be able to convince your counterparties of it.”
The S.E.C. assumed that Bear, or any other investment bank, could always borrow against securities it owned. It assumed that lenders would put up at least 93 percent of the value of those securities, and as much as 97 percent for the safer ones.
In a working paper for the National Bureau of Economic Analysis, prepared for a conference to be held next week at Cambridge University, Mr. Kane assigned some of the blame for the current credit crisis to international regulatory competition, in which national regulators, fearful of seeing business go overseas, dared not be too tough.
Instead, regulators from around the world agreed on common capital standards, the latest version of which is known as Basel II. That standard has loopholes that allowed banks to add lots of leverage, some of it pushed off balance sheets in ways that obscured the risks that remained and minimized the apparent need for capital. …
“A severely overleveraged banking system may be portrayed as an accident waiting to happen,” Mr. Kane wrote. “A regulation-induced crisis occurs when misfortune impacts a banking system whose managers have made their institutions vulnerable to this amount and type of bad luck.”
For now, market revulsion is limiting leverage in the system and driving banks to raise more capital if they can. Mr. Cox told a Senate hearing Thursday that the Basel committee should think more about liquidity. But there has been no admission from regulators that they erred in letting leverage get so far out of hand that a “well capitalized” company could not find anyone willing to lend it money without government help.
Third is “the assets the Fed took are fine.” Steve Waldman, who took the trouble to read and parse an attachment to Timothy Geither’s presentation that set forth the terms and conditions for the operation of the LLC that will hold these positions., focuses on the disclosure that some of these assets included related hedges, which are derivatives. More important, Waldman concludes that the Fed isn’t on the hook for just $29 billion but could wind up stumping up more:
It’s official. The LLC that the Fed and J.P. Morgan recently formed to manage $30B Bear Stearns assets has taken over a portfolio of derivative positions along with those assets. Those positions involve both rights to receive and obligations to pay whose value may depend upon both circumstance and counterparty quality. Of course, if liabilities associated with those positions ever exceed the value of the LLCs assets, the limited liablity company could declare bankruptcy, so in theory, the Fed’s maximum exposure is $29B. But, if, out of reputational concern or to promote systemic stability, the Fed would inject capital rather than let the LLC default, then the Fed has indeed become a counterparty of last resort.
Looking simply at the behavior of the main actors, Michael Shedlock concludes these instruments can’t be all that hot. From Shedlock:
This is galling. Everyone is praising the quality of the assets offered to the Fed as collateral, but JPMorgan would not take them outright. Why not? And while the Fed is on the hook for fallout from those assets, what about the other assets JPMorgan picked up for next to nothing? What are those worth? Was JPMorgan acting like a “responsible corporate citizen” or a vulture financing corporation?
Fourth was Geithner’s presentation. Geithner is generally very well regarded, yet I have come to the view that as head of the New York Fed, he was in a position to have seen what was going awry, yet remained blind alternative courses of action.
He gave a very long speech, parts of which seemed designed to run out the clock so as to reduce the time available for questions (does the panel really need a discussion of the history of the Fed?). Read this section, which came at the beginning:
This was a period of rapid financial innovation—particularly in credit risk transfer instruments such as credit derivatives and securitized and structured products. There was considerable growth in leverage, greater reliance on ratings on structured credit products and a marked deterioration in underwriting standards.
The innovation in financial products was accompanied by a dramatic increase in the amount of financial intermediation occurring outside the core banking system. The importance of securities broker-dealers, hedge funds, and mutual funds in the financial system rose steadily. Off-balance-sheet vehicles of various forms proliferated, and increased concentrations of longer-dated assets were held in funding vehicles with substantial liquidity risk.
In a speech he gave a bit more than a year ago, Geithner covered much the same ground (without the road kill details we now have) framed more positively, and pointed out that only 15% of the non-farm credit extension was via banks. We noted at the time:
Geithner has no objective foundation for his rosy view. He has essentially admitted the Fed and other regulators lack a complete, or even good, picture of what is happening. We’ve had money supply growth well in excess of GDP growth, and loose monetary conditions can obscure underlying weaknesses. His argument boils down to,”Our current structure and distribution of risks is outside the bounds of anything in financial history. We can muster some arguments as to why this should be OK, and so far, it has been OK.” I don’t find that terribly convincing.
And in that speech, he in effect said it was OK for regulators to supervise only in the most minimal way:
We cannot turn back the clock on innovation or reverse the increase in complexity around risk management. We do not have the capacity to monitor or control concentrations of leverage or risk outside the banking system. We cannot identify the likely sources of future stress to the system, and act preemptively to diffuse them.
The most productive focus of policy attention has to be on improving the shock absorbers in the core of the financial system, in terms of capital and liquidity relative to risk and the robustness of the infrastructure.
These issues are the principal focus of day-to-day supervision and market oversight in the major financial centers around the world. The Federal Reserve is actively involved in a range of efforts, working closely with the primary supervisors of the major global financial institutions and the critical parts of the financial infrastructure, to encourage further progress. In this context, we are working to put in place a stronger regulatory capital regime and to strengthen the capacity of firms to absorb losses in stress conditions. We are encouraging more sophisticated and more conservative management of credit exposures in over-the-counter derivatives and structured financial products, as well as of exposures to hedge funds. And we are encouraging a range of efforts to modernize the operational infrastructure that underpins the over-the-counter derivatives markets, and to improve the capacity of market participants to manage a major default.
How can you “encourage” behavior changes among parties you don’t regulate? Where you don’t have enough of a view of what they are doing to even suggest where they might need to trim their sails?
Yet today, the Fed’s and Treasury’s message to Congress was: we withstood this test, the system works, butt out.
They should consider the warning of General Phyrrus: “One more such victory, and we are lost.”